Don't Stress Your Stress Test

The results of the latest stress tests on European banks are expected to be released at 10:00 am CET (5:00 am ET). The tests cover a little more than 50 of Europe's largest banks, with around 80% domiciled in the Eurozone.

The banks will be tested under two scenarios. The first scenario is EC's economic forecasts made last year. That is the baseline. The second is a stress scenario developed by the European Banking Authority (EBA) and the European Systemic Risk Board. This scenario includes shocks in numerous markets.

Indications from officials indicate there will not be a pass/fail test. The key is whether capital levels remain sufficiently robust. If not, the bank will receive "guidance" from the ECB. Simply because a bank is found in need of capital, it does not mean that it must address the need immediately or be immediately subject to resolution procedures.

The focus has been on Italian banks. A local paper reported today that of the five Italian banks that were tested, only one would require more capital. It is not surprising that it is Banco Monte Dei Paschi di Siena that needs capital. The report indicated that Intesa, Bano Popolare, and Ubi Banca are the upper end of the EBA's capital range, while Unicredit was in the middle to the high part of the range. Monte Paschi, in contrast, is classified as a higher risk.

Italy is not the only country engaged in negotiations with EU officials over state aid for banks, so is Portugal. Its banks are perceived to be undercapitalized and saddled with bad loans (estimated ~30 bln euros). Estimates of the amount of capital needed by Portuguese banks are up to around eight bln.

Between three and four bln euros may be needed just to compensate for the bank-financed resolution fund that bailed out Portugal's Novo Banco (2014). The government is trying to facilitate a sale of the bank, but last September rejected all three shortlisted bids. An announcement about another attempt is expected next month, though the EU has extended the official deadline until August 2107. Portugal is also in talks with the EU over recapitalizing state-owned Caixa Geral de Depositos, the country's largest bank. Reports show a wide range of estimates of its capital needs--2 to 5 bln euros.

However, it is not just about the periphery. Germany's largest bank has been in the news. It reports its earnings two days before the stress test results. There are some reports that suggest some Nordic banks may be pressed tough scenario for Sweden and house prices. Austrian banks may also be at risk from bearish economic assumptions and contagion from central and Eastern Europe. Some reports also suggest The Netherlands may have some issues too that will surface in the stress test.

The issue is not whether the state can inject capital into the banks; they can. The issue is what private sector investors have to take a loss (bailed in) before taxpayer funds can be used. There are various and conflicting proposals, but everyone says they want to adhere to the rules. However, it is almost like a sporting event, where the violation of the rules (fouling) is incorporated into the rules themselves.

Specifically, taxpayers’ money could be used to cover a capital shortfall, according to the Bank Recovery and Resolution Directive, without being a resolution event (bailing in subordinated creditors) when it needs to avoid "a serious disturbance in the economy of a member state and preserve financial stability." What makes this particularly relevant in Italy is that a painful resolution process would jeopardize the country's financial and political stability.

It would likely make it less likely that the referendum for constitutional changes (emasculate the Senate) would fail. Italy's Renzi has indicated he would resign if the referendum were not approved. Although he was trying to make a point, linking the referendum to the tenure of the government is reckless. It might be even on par with Cameron's EU referendum. Polls suggest the Italian referendum not drawing stronger support.

The Five-Star Movement (5SM) has become the largest party in Italy, according to some surveys. The 30-year old inexperienced and uneducated (formally) leader of the party in parliament, Luigi Di Maio wants to the full nationalization of Monte Paschi and a (non-binding) referendum on EMU membership (not EU). The 5SM is also opposed to the constitutional changes Renzi proposes on grounds that it concentrates too much power in the premier. Maio may be emerging as Renzi's most likely challenger.

Professor at Columbia University. Recipient of the Nobel Memorial Prize in Economic Sciences in 2001 & the John Bates Clark Medal in 1979. Author of "Freefall: America, Free Markets", "The Sinking of the World Economy", "Globalisation and its Discontents" & "Making Globalisation Work".

Dr Steinbock is an internationally recognized expert of the multipolar world. He focuses on international business, international relations, investment and risk among all major advanced economies and large emerging economies. In addition to advisory activities (www.differencegroup.net), he is affiliated with India China and America Institute (USA), Shanghai Institutes for International Studies (China) and EU Center (Singapore). For more, please see http://www.differencegroup.net/. Research Director of International Business at India China and America Institute (USA) and Visiting Fellow at Shanghai Institutes for International Studies (China) and the EU Center (Singapore).

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